Question: How can you take risk off the table in front of an event without exiting your position?
Answer: Create a synthetic straddle
Options were created to help reduce risk or assist in the potential for generating an income on a current position. Over the years, many traders have found speculative uses for options. It was a natural progression as options are a great tool for creating very defined strategies, whether their goal is risk management or a safer speculative trade.
With options you can take advantage of market movement or volatility. Using options for speculation works but many prefer to use them as they were originally designed.
Whether you are just learning about option strategies or you are a seasoned pro, there is a very good chance you have heard of, and maybe even executed, a straddle.
A straddle is a relatively neutral position that is created by buying an at-the-money call and put in the underlying at the same strike price, or selling an at-the-money call and put at the same strike.
If you purchase the at-the-money call and put you are long the straddle; if you sell the at-the-money call and put you are short the straddle.
Straddles, long or short, often are used around news events that can create spikes in volatility when a trader is uncertain as to where the underlying will go in the short term.
Think about an earnings announcement in the case of equities; crop report in terms of agricultural markets or GDP, CPI or unemployment in the case of financial futures. A report way out of line from expectations could initiate a stop or create a huge move against you in an existing position. However, you may want to hold onto your position for the long-term and simply want to take some of that short-term risk off of the table.
In a situation where we know that a news event is going to affect significantly the market we are trading, but we do not know what the outcome of the event is going to be or which direction it will move the market, it makes sense to neutralize a position.
Assume we have two weeks to prepare. Let’s say we own100 shares of the infamous XYZ underlying. What can we do to manage our risk, and match our position to the sentiments laid out above? Turn our underlying position into a synthetic straddle.
If we own 100 shares of XYZ we will own 100 deltas. To neutralize the position we will have to pick up 100 negative deltas. This can be accomplished by buying two at-the-money XYZ puts with a .50 delta. The resulting position is long 100 shares of XYZ and long two at-the-money XYZ puts.
We now have accomplished the neutrality desired. If the market goes up or down by more than the purchase of the puts we stand to benefit. If volatility increases while we own the puts, we stand to benefit; if there is little movement in the underlying and volatility decreases we lose, but not much. We have weathered the storm and can take off our protection.
As we mentioned above, speculative option positions can be based on an expected movement in price or volatility. A straddle is basically a volatility bet and can be used to make a play on changes in volatility.
Let’s use the above scenario but say we have no position. We expect a news event, perhaps a contested election that has the market pretty tame, waiting to see the outcome. Either outcome will lead to a large move but we are not sure of the direction. We buy a straddle expecting a spike in volatility. When the event occurs and volatility spikes, our long straddle is profitable without us having to pick the direction of the market.
Mike Cavanaugh is an investment advisor for knowyouroptionsinc.com.